Relative Resource Managers - Assignment Example

Relative Resource Managers Answer a) Every business needs adequate liquid resources to maintain its day today and other long-term obligations. Profitability along with liquidity is required by every company to survive in the long-term and this can only be possible if a company acquires proper funds and uses it in profitable project. A public limited company has two options to raise finance, i) equity finance and ii) debt finance. Equity finance is raised by a new issue of equity shares or rights issues. A public company wishing to obtain equity funds may do so by obtaining a listing on, a) Alternative Investment Market, b) Recognized Investment Exchange, e.g. Chicago Stock Exchange or the London Stock Exchange. A company can obtain a stock exchange listing for its shares through an offer for sale, a prospectus issue, a placing or an introduction. There are certain conditions which are usually put up by stock exchanges; Merchiston Venture plc needs to meet up those conditions to be able to get a stock exchange listing. There are many advantages and few disadvantages with having a stock exchange listing. Companies usually evaluate all those benefits and cons according to their structure and then decide on getting such stock exchange listings. The advantages for Merchiston Venture plc and its shareholders are; A stock market listing enhances the number of potential investors. It may also improve the company’s credit rating, making debt finance easier and cheaper to obtain. Shares that are traded on the stock market can be bought and sold in relatively small quantities at any time; hence existing investors can easily realize a part of their holding. Listed companies are commonly believed to be more financially stable. Listing may improve the image of the company with its customers and suppliers, allowing it to gain additional business and to improve its buying power. A listed company is in a better position to make a paper offer for a target company than an unlisted one Employees would be given extra benefits to motivate them via share options The disadvantages or the drawbacks Merchiston Venture plc and its shareholders might suffer are; There might be an increased risk of the company being taken over by other potential investors or competitors. Companies listed with the stock exchanges have the extra burden of complying with the legal and regulatory requirements of the Stock Exchanges and other standards of corporate governance. A significant loss of control to a wider circle of investors reducing the potential voting or other rights of the existing shareholders. The costs associated with getting the stock exchange listing are extensive, plus other costs to be incurred such as extra expenditure required to comply with the standards of corporate governance. Answer 1 b) Every company’s performance needs to be assessed to ascertain its position and to ensure whether the company is meeting its objective of maximizing shareholder wealth. Many different techniques are used but primarily ratios are used to analyze the company’s financial and operational performance. The ratios are compared with any benchmark, and budget, similar company or the industry in which the company operates. The information available in Merchiston Venture plc is the industry benchmark; hence the appraisal of Merchiston Venture plc would be done by comparing its financial result with industry financial indicators. PROFITABILITY RATIOS Return on Capital Employed (ROCE) = Profit before interest and tax Total Assets – Current Liabilities The Return on Capital Employed ratio (ROCE) tells us how much profit has been earned from the investments the shareholders have made in their company. ROCE should always be higher than the rate at which the company borrows, otherwise any increase in borrowing will reduce shareholders earnings. The ROCE for Merchiston Venture plc for FY 09 is approximately 30% and in the industry’s average, i.e. the benchmark available is 22%. The ROCE value of 30% seems pleasing for the shareholders as it is above the industry standard which clearly suggests that Merchiston Venture plc is a good profitable company and it has good prospect for its shareholders. Return on Equity (ROE) = Net Income ÷ Shareholders equity (not including preference shares) When considering the Return on Equity, a company’s profitability is analyzed and reviewed. ROE measures a company’s profits that it has generated from the funds being invested by the shareholders. Preference shareholders are not included as they are not considered the owners of the company, they have their own interest prevailing before the company’s and that is to receive their fixed percentage of dividends. The ROE (post tax) for Merchiston Venture plc is approximately 21% (i.e. 6 ÷ 28). Hence the ROE for Merchiston Venture plc is better than the industry standard of 14% (post tax). This comparison once again assures that Merchiston Venture plc’s profitability is very good and better than the industry standard, hence the company seems a profitable venture for investors. Following all these profitability ratios are the Liquidity ratios, these ratios review the liquidity position of a company. LIQUIDITY RATIOS Current Ratio = Current Assets Current Liabilities The current ratio is a means to measure the liquidity of a company, it is also known as the working capital ratio. It is an indication of a companys ability to meet its short-term debt obligations; the higher the ratio, the more liquid the company is. If the current assets of a company are more than twice the current liabilities, then that company is generally considered to have good short-term financial strength. If current liabilities exceed current assets, then the company may have problems meeting its short-term obligations. The current ratio for Merchiston venture plc is 1.15: 1 ( 23 ÷ 20 ), hence it shows that Merchiston venture plc is in a good position to meet its short term obligation. On the contrary the industry standard is 1.18: 1, which shows that Merchiston venture plc is not doing good when compared to the industry standard, but this is not an alarming situation for the company as the Current Ratio suggests that Merchiston Venture plc has enough current assets to meet its short term obligations when they arise. Acid Test Ratio/Quick Ratio = Current Assets less Stock ÷ Current Liabilities. The Quick Ratio is yet another means to measure the liquidity of a company. The stock is not added into the current assets so as to ascertain most liquid assets (that are either cash or generate cash very quick, not as stock which requires time to re-sell) of a company. Those liquid assets are then divided by the current liabilities to measure the ability of a company to pay its short-term obligations as soon as they become payable i.e. within short notice. The Acid Test Ratio for Merchiston Venture plc is 0.65: 1 {( 23 – 10)/20}. This is comparatively low than the house building industry standard of 1.1: 1. Merchiston Venture plc might have problems if their obligation might require real quick clearance, the company might then have problem converting their stock quickly as it would require immediate cash to pay off their instant debts. The other issue that this ratio suggests is that Merchiston Venture plc has too much of its cash being stuck up in the form of stock. This might sometimes also suggests that a company is also overtrading. Gearing or Debt/Equity Ratio = Total Debt ÷ Equity. Gearing is a measure of financial leverage, demonstrating the degree to which a firms activities are funded by owners funds versus creditors funds. The ratio is concerned with how much the company owes in relation to its size and whether it is getting into heavier debt or improving its situation. The gearing for Merchiston Venture plc is 17.8% (5 ÷ 28) which suggests that the company is financed 17.8% via debt and the rest of the finance i.e. 82.2% is financed via equity. The industry financial indicators for the house building suggest almost the same outcome i.e. 18%. Hence there is nothing much to compare between the industry standard and Merchiston Venture plc result. The only topic that is debatable is the issue of preferring the mode, i.e. either equity finance or debt finance, which should be utilized more, both have their advantages and disadvantages and every company uses them in accordance with their own structure and preference. STOCK MARKET RATIOS Interest Cover = Earnings before interest and tax ÷ Interest Expense Interest cover is used to determine how easily a company can pay interest on its outstanding debt. Interest cover is a measure of financial risk which is designed to show the risk in terms of profit rather than in terms of capital value. The interest cover for Merchiston Venture plc is 3.3 times (10 ÷ 3). The industry comparison is 5.2 times which is higher. The interest cover for Merchiston Venture plc suggests that it might have problems if it is to raise any more debts on which it has to pay interest, gradually the company should try to pay off its debts so as to make the interest cover more preferable. Besides all this the major issue for the company might be because of the fact that they have borrowed bank overdraft and the bank might be charging higher rates for that. The interest on the debentures is not the issue because it is a long term loan the overdraft is a short term loan and might cause problems for the company because of the interest rate that the company might be charged and because of its short term nature, i.e. it might be repayable in less than a year. Dividend Cover = Earnings per Share (EPS) ÷ Actual Dividend for ordinary shareholders. EPS = Profit attributable to ordinary shareholder ÷ Average number of Ordinary shares Average no. of ordinary shares = 4 ÷ 0.5 = 8 EPS = 6 ÷ 8 = 0.75 pence Dividend Cover for Merchiston Venture plc = 0.75 ÷ 0.5 = 1.5 times The industry standard is 2.6 times, which suggest that Merchiston Venture plc retains major part of their profit and pays out less to their shareholders. This might be a negative sign for any potential future investors in the company. P:E Ratio = Market price of share ÷ EPS (in pence) The P:E raio cannot be calculated for Merchiston Venture plc as there is no active market for the company’s share, its market price cannot be ascertained. Answer 1 C i) Merchiston Venture plc should try and restructure its balance sheet by eliminating the loans from the face of its balance sheet to strengthen it. The bank overdraft taken by the company should be repaid so as to ensure that less loans are left over to be dealt with, this would make the company balance sheet more favorable. The 14% debentures taken by Merchiston plc can also be removed either by paying them off via cash or by offering the debenture holders to convert their debentures into shares once Merchiston Venture plc gets listed on the Stock Exchange. Answer c ii) Merchiston Venture plc requires some changes in their financial policies. Merchiston venture plc would only be able to raise finance if investors think that the returns they can expect are satisfactory in view of the risks that they are taking. Hence the company should focus on factors that are admired by the investors. Information that is relevant to market prices and returns is available from published stock market information and in particular from certain stock market ratios. The stock market ratios, which an investor looks and admires in a company prior to any investment in a company, these ratios should be made appealing for the investor. The company should create a policy of giving more dividends to its share holders, this would also increase the dividend cover of the company making it more attractive for the investors and would also increase the Earnings per Share for the company. Merchiston Venture plc’s ROCE and the ROE are both good and are both above the industry standard and this would be a plus point for them as well to raise finance. The EPS and the dividend cover should also be increase accordingly. Answer 2 a) YEARS Cash Flows 0 1 2 3 4 5 (£’000) License Fee (300) (300) (300) (300) (300) Equipment (5,200) (5,200) Scrap Value 2,000 Sales 7,400 8,300 9,800 5,800 Wages and salaries (550) (580) (620) (520) Materials and Consumables (340) (360) (410) (370) Overheads (100) (100) (100) (100) Hired Machine (150) Interest charges (650) (650) (650) (650) Net Cash Flows (5,200) (5,500) 5,310 6,310 7,720 5,860 D.F @ 10% 1 0.909 0.826 0.751 0.683 0.621 Disc. Cash Flows (5,200) (5,000) 4,386 4,739 5,273 3,639 NPV @ 10 % Discount Factor = -5,200 – 5000 + 4,386 + 4,739 + 5,273 + 3,639 = 7,837 Assumptions; The reason the Survey cost is irrelevant is that it’s already done and paid for, making it a sunk cost. Whether or not Oil Associate plc decides to buy equipment and become more productive has no impact on the money already spent on the geological survey. They can’t recover it, it doesn’t increase or decrease because of any decision they make…it’s a sunk cost. Depreciation expense is a phantom cash flow and impacts cash flows only insofar as taxes are reduced by depreciation expenses, the so-called depreciation tax shield. But, since this problem ignores taxes, depreciation expense is irrelevant. Usually the working capital is recovered back at the end of the final year of the project, but that has not been done in the above calculation as it was not mentioned in the question. It is assumed that the interest charges given in the P & L extract due to the Working Capital requirement and it is not any other interest charge to the company. Internal Rate of Rate (IRR) = a + Na/(Na – No) * (o – a)% a = Lower rate of interest o = Higher rate of interest Na = NPV at lower rate of interest No = NPV at higher rate of interest Ideally if Na should be a positive value and No should be a negative value. Assumption; NPV calculated at 40% cost of capital, so as to get a negative NPV value. = {(-5,200*1) + (-5,500*0.71) + (5,310*0.51) + (6,310*0.36) + (7,720*0.26) + (5,860*0.186) = -1,028 Hence, putting all the values in the IRR equation; = 10 + {7,837/(7,837 – (-1028)} * (40 – 10) = 10 + {7,837/8865 * 30} = 10 + 26.5 = 36.5% Answer 2 b) NPV method of investment appraisal is to accept projects with a positive NPV. NPV is the value obtained by discounting all cash outflows and inflows of a capital investment project by a chosen target rate of return or cost of capital. The project seems worthwhile as it has a positive Net Present Value (NPV), hence it should be accepted and carried out accordingly. The IRR method of investment appraisal is to accept projects whose IRR (the rate at which the NPV is zero) exceeds a target return. The IRR is calculated using interpolation. Besides the NPV, the IRR calculated also suggests the project to be worthwhile for Oil Associate plc unless Oil Associate plc’s required rate of return is greater than 36.5%. All in all, this project seems profitable for Oil Associate plc and hence should be accepted. Answer 2 c) Inflation is a feature of all economies and it must be accommodated in financial planning. In the above scenario, the effect of inflation rate has not been considered. As the inflation rate increases, so will the minimum rate required by an investor. The other issue when evaluating inflation is to ascertain, which rates to use for cash flow discounting, either the money rate or the real rate. If cash flows are expressed in terms of the actual number of the currency that will be received or paid on various future dates, the money rate is used for discounting, where as if the cash flows are expressed in terms of the value of the currency at time 0, we use real rate. Not all costs and benefits will rise in line with the general level of inflation. Each cost and benefit might inflate at a different rate and this can also sometimes prove disadvantageous e.g. costs rising more proportion to revenue. In Oil Associate plc’s case the expenses might rise more in proportion than the revenue earned by the project. To overcome all these issues, the correct rate for inflation rate should be applied to the cash flows and later it should also be correctly ascertained, at which rate shall the cash flows be discounted (real rate or the money rate). Allowing for all these calculations would provide a better picture of the feasibility of Oil Associate plc’s capital investment project regarding oil exploration. Bibliography Top of Form OPEN UNIVERSITY. (1999). Financial strategy. Open University course. Milton Keynes, Open University. Bottom of Form Top of Form ARNOLD, G. (2005). Handbook of corporate finance. 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